By: Frank Armstrong
By: Frank Armstrong, CFP®, AIFA®
Way back in the 20th Century people actually believed that superior managers could consistently add value over and above a simple market index by identifying mispriced stocks and properly gauging market swings. Acolytes of this quaint notion believed that by implementing strategies designed to capture the benefits of this superior insight, active managers could generate “alpha” or positive performance over and above market returns.
These assertions were widely accepted and perhaps not even unreasonable in an environment where there was no data to test the theory against and no benchmarks to compare performance to. A huge and highly profitable investment management industry sprung up and thrived based on this premise.
The corollary was that these superior managers could be identified through diligent and prudent research.
So, a second whole industry of consultants emerged to guide pension and institutional investors to select the most skillful of these professional managers. Through extensive proprietary research they would identify the “good” managers and distinguish them from the “bad” managers. In the real world, more than a few have some kind of financial arrangement with the managers that they recommend which invariably introduces an enormous conflict of interest. But, these conflicts of interest were seldom disclosed to the clients who innocently believed that they were receiving unbiased advice.
Detecting alpha turned out to be fiendishly difficult. Excess performance appeared and disappeared like so many ghosts and goblins. A simple sort by past performance reliably failed to generate alpha in future time periods. So, if your compensation depends on identifying alpha, you must turn to more qualitative measures to justify your existence. Qualitative measures are ideal for the task because they can be re-evaluated after the fact to support any desired conclusion. If numbers and science won’t do the trick, a little mumbo jumbo voodoo magic just might bamboozle the clients.
The Manager Based Approach
The consulting industry seized upon the “Three Ps” as a method to explain the ever so elusive alpha. A manager’s Philosophy, Process and People were assumed to predict the organization’s ability (or inability) to generate alpha.
There are hundreds of variations on this theme, but here’s how absoluteastronomy.com explains the concept:
Process and People
The 3-Ps (Philosophy, Process and People) are often used to describe the reasons why the manager is able to produce above average results.
- “Philosophy” refers to the over-arching beliefs of the investment organization. For example: (i) Does the manager buy growth or value shares (and why)? (ii) Does he believe in market timing (and on what evidence)? (iii) Does he rely on external research or does he employ a team of researchers? It is helpful if any and all of such fundamental beliefs are supported by proof-statements.
- “Process” refers to the way in which the overall philosophy is implemented. For example: (i) Which universe of assets is explored before particular assets are chosen as suitable investments? (ii) How does the manager decide what to buy and when? (iii) How does the manager decide what to sell and when? (iv) Who takes the decisions and are they taken by committee? (v) What controls are in place to ensure that a rogue fund (one very different from others and from what is intended) cannot arise?
- “People” refers to the staff, especially the fund managers. The questions are: Who are they? How are they selected? How old are they? Who reports to whom? How deep is the team (and do all the members understand the philosophy and process they are supposed to be using)? And most important of all, how long has the team been working together? This last question is vital because whatever performance record was presented at the outset of the relationship with the client may or may not relate to (have been produced by) a team that is still in place. If the team has changed greatly (high staff turnover or changes to the team), then arguably the performance record is completely unrelated to the existing team (of fund managers).
Whenever a past recommendation failed to meet expectations, the consultants could always assemble a story that one of the Three Ps had broken down.
Typical insights (excuses) the consultant might offer for a management disappointment are:
- They lost a key analyst.
- They have strayed from their philosophy of Growth at a Reasonable Price (GARP).
- They have switched from a top down to a bottom up screening process.
During periodic reviews, managers that fall below their benchmark may be placed on a “watch list” similar to probation. The watch list acknowledges that the manager has failed to meet expectations, but that his underperformance will be tolerated for some time into the future in the vain hope that more diligent application of the Three Ps will improve performance. How long the fund should tolerate demonstrated underperformance before pulling the trigger becomes just another qualitative judgment. But, cumulatively, this underperformance compromises the total fund’s return significantly.
The consultants are, of course, only too happy to replace the offending manager with another “superior” manager chosen through their closely guarded proprietary process.
No matter what they say, the consultant’s primary screening tool is past performance. They are highly unlikely to recommend a fund with miserable past performance no matter how well the fund manages the Three Ps.
Unfortunately, the client’s portfolio is subjected to continuous rotation of managers through the “fire and replace” methodology the consultant uses to justify his existence. We all know that past performance is not an indication of future performance. Managers selected for past performance more often than not go on to have mediocre future performance until fired and replaced.
It follows that clients end up with portfolios comprised of managers with superior past performance, but because the client didn’t hold them while they were generating that performance record, the client’s portfolio experiences sustained underperformance. The fire and replace philosophy offers no solution to this enigma.
In the last half of the 20th century, academics and researchers developed extensive databases on market performance, sophisticated measurement tools and appropriate benchmarks in each market segment. The overwhelming weight of the evidence indicates that managers cannot reliably add value (alpha) in excess of the costs that they bring to the problem.
To be completely clear, active management adds no value and the Three Ps explain nothing about past performance or give us any indication of likely future performance. They are as relevant to modern finance as alchemy and astrology.
So, is there a more rational, effective and prudent method to construct institutional portfolios?
A Market Based Approach
Everything we have learned about finance tells us that the best explanation of portfolio performance is the asset allocation. Across the entire spectrum of managed investments, costs reduce returns and tracking error increases risk. Neither of these are a benefit to the investor. In other words, the expected return from active management for individual security selection and/or market timing decisions is reliably negative.
The modern alternative is a market based approach rather than a manager based approach. This methodology, based on financial theory, market research and institutional best practices, concentrates effort where it will have the highest impact on portfolio performance: asset allocation, exposure to the risk dimensions that generate return, diversification, cost control, risk assessment and reducing tracking error. By explicitly embracing efficient market theory and abandoning the false hope of beating the market, the fund actually can improve performance.
Implementation through passive structured vehicles like index funds and exchange traded funds (ETFs) virtually eliminates the prospect of underperformance against the benchmark, controls cost to the practical minimum, reduces uncompensated risk, and greatly simplifies the investment process while allowing the fiduciary to focus on the issues that really count.
With that in mind, a review of active manager performance based on adherence to the Three Ps coupled with a fire and replace investment policy is not only a total waste of time, it’s an imprudent waste of beneficiaries’ money. The Three Ps are as relevant in today’s financial practices as asking the manager’s astrological sign.